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Interview with Julio Velarde, President of the Central Reserve Bank of Peru

July 24, 2018

Economic growth was disappointing in 2017; how much of that was because of political turmoil?

Julio Velarde: In 2017, the Peruvian economy faced two large adverse shocks: the first was the El Niño phenomenon, which seriously damaged basic infrastructure in northern Peru and had a negative impact on consumption; and the second was the Odebrecht corruption investigation, which affected Peru’s most important construction companies. Both inhibited aggregate expenditure and reduced annual growth to 2.5%. However, as their impact began to dissipate, growth recovered to 3.2% year-on-year (yoy) in the first quarter of this year – even with persistent political turmoil; and leading indicators point to growth of 5% in the second quarter. In April and May, electricity consumption growth reached 4.5% yoy; cement consumption 8.3% yoy; the import volume of durable and capital goods 13.8% and 10.2% yoy, respectively; public investment 13.9% yoy; and bank credit 8.2% yoy. Peru’s cyclical rebound is supported by growing terms of trade, global recovery at a solid pace, and expansionary monetary and fiscal policy. Political turmoil might have some transitory effect on investor confidence but it has not significantly affected growth prospects.

Copper prices are rising again: can we expect Peru to return to the 6% annual growth seen in the last commodities boom?

JV: The rebound in commodity prices partly explains the cyclical recovery in the second quarter. We expect growth to accelerate further to 4.2% next year, as potential output will increase in response to higher investment in 2018. However, in contrast with the previous period of high commodity prices, this time global financial conditions are not equally expansionary. Therefore, for sustaining medium-term growth at around 6% — which is feasible, given Peru’s potential, particularly in agroindustry — it is critical to press forward with structural reforms, particularly in the labour market. It is also crucial to cut red tape and improve the quality of public goods. Otherwise, we expect medium-term growth only reach 4.5% to 5.%.

To what extent has Peru managed to diversify its economy away from mining and how far do you see this trend of diversification continuing?

JV: In recent years Peru has experienced continuous production diversification. Non-primary exports (NPXs) multiplied tenfold to $11.7billion in 2017, which was 5.4% of GDP, from $1.2billion in 1994, or 2.8% of GDP. In contrast with primary exports, which are mainly Peru’s mineral output, NPXs are higher value-added goods with more impact on GDP, productivity, income, and employment.

We expect export diversification to continue in the coming years…

While primary exports have been driven mostly by commodity prices, NPX performance has been linked mainly to an increasing volume of industrial agricultural exports. In recent years, Peru has become a leading exporter of artichokes, asparagus, avocados, and blueberries. Sustained NPX growth is due to both an increase in the number of destinations, facilitated by free trade agreements, and product diversification. In 2003-2017, NPX destinations increased to 217 from 166; and the number of export items soared to 4,453 from 3,743.

We expect export diversification to continue in the coming years, particularly through an expansion of the agricultural frontier. A number of ongoing agricultural infrastructure projects should increase agricultural land by 70%, to 340,000 hectares up from 200,000.

Most analysts think that the Peruvian cycle of monetary easing is coming to an end; are they right?

JV: Since last year, we cut the interest rate six times, bringing it down to 2.75% from 4.25%, a level considered appropriate as long as inflation remains on target and output is below potential. Future changes in the monetary stance will depend on new information, particularly on inflation expectations and how fast the cyclical recovery reduces the output gap.

This government attempts to close the fiscal deficit, including by raising taxes on fuel, cigarettes and alcohol; will these tax increases hit consumer demand?

JV: These tax increases are important for signalling an important fiscal consolidation envisaged to reduce the deficit to 1% of GDP by 2021 from 3.1% in 2017. In this context, using instruments with the least impact on economic recovery is the best choice.

Estimates of the effect on the income multiplier are substantially lower than for other fiscal instruments. It’s just 0.25 of income, versus 1.42 for investment and 0.93 for current expenditure. Thus, the increase in income will have little effect on economic activity. The increase in tax revenues does not imply a significant reduction in disposable income. The government estimates that, in terms of tax collections, the excise tax hikes will increase tax revenues by 0.3% of GDP, of which S/2.1billion from the excise tax and the rest from the VAT, as the former is part of the tax base of the latter.

What is the most significant macroeconomic challenge that Peru faces at the moment?

Peru needs to speed up the implementation of structural reforms, particularly for enhancing productivity and competitiveness, mainly cutting red tape and improving the quality of education and other basic public goods and services, such as infrastructure and health care. Delaying these reforms will likely reduce Peru’s chances of achieving a faster “catching up” process.

Despite many attempts, Peru has been unable to reduce its infrastructure deficit; how much impact could ‘unblocking’ infrastructure projects have on the Peruvian economy?

Public investment has decreased over the last four years, to 4.5% of GDP in 2017 from 5.8% in 2013. The causes of this decline are diverse, from management and contractual complications to policy design problems, such as the 2016 fiscal adjustment. Over the next few years, natural disaster reconstruction efforts, together with Pan American Games-related works, are envisaged to become major public investment drivers.

The 2018 fiscal budget foresees losses amounting to $795million, which is 0.3% of GDP, due to significant implementation problems. In this context, unlocking investment projects should have welcome short and long-term impacts on economic activity. The unlocking effect is expected to be substantial, considering that the multiplier effect of public investment is currently estimated at around 1.4.

unlocking investment projects should have welcome short and long-term impacts on economic activity…

Long-term effects are bound to be even larger due to the increase in productive capacity. Two irrigation projects currently in the process of being unlocked, Majes Sihuas in Arequipa and Chavimochic III in La Libertad, carry investment commitments of $1.2billion and are envisaged to expand the agricultural frontier by 100 thousand hectares. Private firms have announced $15.5billion in infrastructure projects, of which only 35% are associated with ongoing projects.

Additionally, the reform of the public investment system, introduced at the end of 2016 and applicable to new projects, should result in greater efficiency and effectiveness of investment management. Regarding the first element, resources will be directed to bridging the largest infrastructure gaps, while the second will serve to streamline administrative requirements for project preparation.